Small caps on the radar

Buying small-cap shares was a no-brainer for fund managers last year. Now it’s a headache. Valuations are rapidly improving as the market goes through a correction and investors dump smaller stocks for defensive blue chips and cash. But small caps are the last asset class to hold if volatility persists and risk appetite wanes. One bad year can crush portfolios.

When the fog clears, investors may look on June as a great month to buy small caps. Certainly the 13 stock-pickers surveyed by the Weekend AFR are becoming more bullish on small- and mid-cap stocks as the latest correction unfolds. Some see great value emerging in beaten-up sectors, such as retail and mining services, and expect more second-half takeover activity. None is aggressively buying small caps just yet. They are targeting select opportunities instead.

Few clear themes emerge from their 27 selections in the two accompanying stories. That is not surprising. This is a stock-picker’s market – not a time to make easy gains from diving into cyclical stocks in anticipation of economic recovery, as happened last year.

Like all good stock-pickers, these investors take a “bottom-up" approach, although it still pays to watch “top-down" information on small caps in deciding when to buy. There are four key arguments in favour of buying small caps now: valuations, domestic economy leverage, takeover activity and market irrationality.

Having traded at parity, and even a slight premium to blue chips last year, aggregate small-cap valuations are back at their average 10 per cent to 15 per cent discount, depending on which broker numbers are used.

Relative valuations for small caps and blue chips are deduced by comparing the prospective price-earnings multiple (P/E) of the S&P/ASX Small Ordinaries index to the S&P/ASX 200 index. The Small Ords is down almost 9 per cent for the year to date, compared with a 7 per cent loss for the S&P/ASX 200, a gap likely to widen if the market retests previous lows.

Small caps have no right to trade at valuation parity to blue chips for long periods. Small companies generally have lower-quality franchises, less management depth, less liquidity and lower dividend yields than blue chips.

Related Quotes

Company Profile

Yet they traded near the same average valuation as blue chips for so long that some thought a structural re-rating of small and mid-cap stocks was under way due to the prolonged outperformance of Australia’s economy. It wasn’t. Investors were just paying silly prices.

The second argument for small caps – higher leverage to the Australian economy – is compelling. Small industrial and resource stocks, by their nature, have fewer offshore operations than blue chips. Their earnings are less constrained by weak United States or European economies. Australia’s stronger fiscal position than that of other Western countries, and China leverage, positions local, small listed companies for strong earnings growth if the domestic economy accelerates in 2011 and 2012.

The third argument – more takeover activity – is equally strong. Big companies are watching valuations of small-cap prey fall and are looking to a stronger economic recovery in 2011. There have already been more takeovers this year, mostly from private equity firms and offshore companies possibly capitalising on a lower Australian dollar. What has not yet emerged are many large Australian companies buying small companies in the same industry as bolt-on acquisitions.

There’s nothing like a few takeovers to spur on Australian boards and executives who have been eyeing assets for years. After raising more than $100 billion in equity capital last year, Australian blue chips are arguably undergeared.

Too much balance sheet cash will dampen average returns on equity, and reducing debt will not boost profits as much as earnings-accretive acquisitions. Takeovers are a more attractive option to drive earnings if economic growth is below-trend.

The fourth small-cap argument – market irrationality – is more subjective. Small caps usually fall first and hardest when shaky markets flush out panic sellers, or as long-term investors’ increase portfolio weightings to defensive blue chips and cash to protect capital.

The “wall of worry" for equity markets seems to add a new layer daily. If it is not more fiscally challenged European countries, it’s oil spills, Middle East or Korean tensions, or Australia’s mining super profits tax. Pessimistic onslaughts are historically long-term buying opportunity for share investors.

Combining these four arguments creates a simple choice for investors: Those who believe sharemarket falls are overdone, and that the Australian economy will outperform other Western economies, should buy small caps. Those who expect prolonged volatility should avoid them.

A good clue is the Australian dollar. An important relationship exists between small-cap indices and the Australian dollar relative to the greenback. A higher Australian dollar is usually accompanied by higher commodity prices, which are good for the growing number of resource companies in the Small Ordinaries index.

A higher dollar also signals higher risk appetite, also good for riskier assets like small caps. Also, small caps typically import more than export, meaning a high currency works in their favour. An Australian dollar back in the US70¢ to 75¢ range may signal a period of sustained small-cap underperformance, while a currency recovery could boost small-cap indices.

Earnings downgrades are also working against small caps this year. The market expects earnings growth for the Small Industrials index of about 30 per cent in financial-year 2011, a big ask if global economic recovery wanes.

Over-optimistic analysts have downgraded more earnings this quarter, the net earnings revisions falling from just under 1.4 earlier this year (1.4 upgrades for every downgrade) to less than 0.7 for the S&P /ASX 300 All Industrials, Macquarie Group research shows. The resource sector’s revision ratio has also slipped to 0.72.

Lower than expected earnings will lift aggregate P/E multiples and make small-cap valuations less attractive against blue chips. Take care relying on aggregate multiples for small-caps indices. For starters, the weighting of resources stocks in the Small Ordinaries index has increased from about 15 per cent to almost 40 per cent in the past five years. Many smaller miners are yet to produce minerals, so have low or no earnings, which distorts the Small Ordinaries’ average P/E. Also, the Small Ordinaries is based on the top 100 to 300 stocks, some of which have valuations more akin to blue chips. It is not the best stock picker’s guide to a market with more than 2000 companies.

The other problem is relying on historic valuation averages. An oft-quoted figure is that the Australian sharemarket trades on an average forward P/E ratio of about 15. It is now around 11 for the ASX / S&P 300 index, having scaled as high as 17 last year.

Aggregate valuations look cheap. But there is an argument for a P/E de-rating, given governments and consumers worldwide are saddled with unprecedented debt, market volatility could stay elevated, and single-digit equity returns could become the norm.

The federal government’s mining super profits tax has also increased Australia’s sovereign risk in the eye of foreign investors – another reason for a lower average P/E multiple for the market. So buying small caps on the basis they are back at historical discounts to blue chips is a harder argument to make.

There is also a view that the Australian economy could underperform relative to the recovering US economy and even some Northern European economies in the medium term.

If this happens, blue-chip companies with offshore earnings exposure, especially in the US, will be more attractive than domestically focused small caps. A falling Australian dollar would provide a second kick to earnings of blue-chip companies that translate foreign profits and debt into Australian-dollar financial accounts. Local investors wanting small-cap exposure may consider investing in products over offshore indices, such as the Russell 2000 index in the US, to get small-cap exposure.

The final factor weighing on small caps is history. Small caps were the top-performing asset class in four of 10 years this decade, and the best-performing asset class in seven of the past 20 years, Morningstar data shows. The Small Ordinaries index produced a stunning 57.4 per cent return in 2009 after gigantic falls the year before, which wiped out several years of gains. The potential for catastrophic losses is why seasoned investors run from small caps during the first sniff of a serious downturn. It is hard to see small-caps outperforming blue chips if current market trends continue.

Clearly, there is no shortage of small-cap challenges. On balance, there is an argument for long-term investors to increase small-cap portfolio weightings cautiously this year. Those with less risk tolerance have little need to rush – another 12 months of small-cap underperformance would not surprise if more earnings downgrades emerge, before upgrades return for financial-year 2012. Small-cap bargain hunters who want to buy now should follow two approaches. The first is seeking small-cap stocks with higher earnings visibility and recurring income. Stocks like the software provider Reckon are an example.

The second approach is selectively targeting deep value plays in retail and mining services – two of the most beaten-up sectors.

Some institutional investors argue retail stocks are a classic “value trap" – valuations look cheap because forecasts earnings are too high. They are probably right. The trick is buying the highest-quality small-cap retailers with good organic growth prospects from store rollouts and other initiatives.

In mining services, focus on companies with a strong work pipeline already locked in and more exposure to producing mines, rather than less-certain exploration projects. Select mining service companies could be a stand-out investment opportunity in 2010 – especially if the mining tax is amended or shelved. Great care is needed due to the earnings risks posed by the tax.